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(Article from Securities Law Alert, July 2015) 

For more information, please visit the Securities Law Alert Resource Center

Section 262 of the Delaware General Corporation Law permits dissenting shareholders in certain merger transactions to petition the court to obtain the “fair value” of their shares. 8 Del. C. § 262. A prerequisite for appraisal rights is that a shareholder must “continuously hold [ ] such shares through the effective date of the merger” (the “Continuous Holder Requirement”).

On July 13, 2015, the Delaware Chancery Court considered whether the Continuous Holder Requirement “bar[s] a beneficial owner” of stock held in fungible bulk by the federal Depository Trust Company (“DTC”) “from pursuing appraisal if there has been an administrative transfer at the depository level.” In re Appraisal of Dell Inc., 2015 WL 4313206 (Del. Ch. 2015) (Laster, V.C.). The court held that “[u]nder current [Delaware] law, the answer is yes.” However, the court stated that if it were “writing on a blank state,” it would “look[ ] through” the DTC ownership structure and “recognize[ ] the custodial banks and brokers as record holders.” The court explained that if Delaware law took this approach, then beneficial owners of stock held by the DTC “would retain their appraisal rights” regardless of any administrative transfers at the depository level as long as “ownership by the relevant DTC participants” remained the same.

The Creation of the DTC System

In the late 1960s and early 1970s, “[i]ncreased trading volume in the securities markets overwhelmed the back offices of brokerage firms and the capabilities of transfer agents,” which could not “cope with the  burdens of documenting stock trades using paper certificates.” The SEC eventually responded by “adopt[ing] a national policy of share immobilization.”

Pursuant to this policy, the SEC created the DTC to hold shares in fungible bulk on behalf of banks and brokers. Instead of issuing shares in the names of the participant entities, the DTC issues all shares in the name of Cede & Co., the DTC’s nominee. Through an “electronic book entry system,” the DTC “track[s] the number of shares of stock that each participant holds.” However, because “legal title [typically] remains with Cede,” “[n]o new certificates are required” when shares of stock are transferred from one owner to the next. The addition of the “DTC to the bottom of the ownership chain” “eliminated the need for the overwhelming majority of legal transfers.”

Today, more than 800 custodial banks and brokers are members of the DTC. While the DTC system “solved the paperwork crisis, it complicated other aspects of the legal system,” including appraisal for dissenting shareholders in the merger context. The DTC eventually “modified its procedures” to “help issuers oversee the surrender of shares.” In the event that “a beneficial owner causes Cede to demand appraisal, [the] DTC removes the shares covered by the demand from the fungible bulk” and “cause[s] the issuer’s transfer agent to issue a paper stock certificate [in Cede’s name] for the number of shares held by the beneficial owner.” By titling the stock certificate in Cede’s name, the DTC ensures that “the same record holder continues to hold the shares for purposes of [Section 262’s] Continuous Holder Requirement.”

Case Background

In February 2013, Dell agreed to a going-private merger transaction. Five institutions that owned Dell stock through custodial banks participating in the DTC system (the “Funds”) exercised appraisal rights for certain of their shares. The DTC then “followed its procedures and issued paper stock certificates in Cede’s name for the Funds’ shares.” However, the Funds’ custodial banks followed a policy of “only hold[ing] stock certificates that are issued in the names of their own nominees.” The custodial banks therefore “instructed Dell’s transfer agent to record a transfer of the shares to [each bank’s] nominee and issue a certificate in [each bank’s] nominee’s name.” While “[t]he Funds remained the beneficial owners” and “[t]he custodians remained the custodians,” “there were [now] new nominees on the stock ledger.”

Dell moved for summary judgment on the Funds’ appraisal claim, “arguing that these back-office steps resulted in new record holders and broke the chain of title for purposes of the Continuous Holder Requirement.”

Following Delaware Precedent, Chancery Court Finds the Continuous Holder Requirement Is Not Met If There Is a Change of Legal Ownership, Even If Beneficial Ownership Remains the Same

The Chancery Court began its analysis with the appraisal statute. Pursuant to Section 262, “‘[a]ny stockholder of a corporation’” may petition for appraisal in connection with certain merger transactions provided the Continuous Holder Requirement is met (quoting 8 Del. C. § 262). The court observed that the statute defines “stockholder” as “‘a holder of record of stock in a stock corporation,’” but “does not define what it means to be a ‘holder of record.’”

The Chancery Court then turned to Delaware precedent. The court found that under prior Delaware decisions, “‘only the person appearing on the corporate records as the owner of stock in the corporation may qualify for an appraisal’” (quoting In re Engel v. Magnavox Co., 1976 WL 1705 (Del. Ch. April 22, 1976) Delaware courts have held that “‘[i]t is the ‘record holder ― not the beneficial owner ― [that] is subject to the statutory requirements for showing entitlement to appraisal and demonstrating perfection of appraisal rights under Sections 262(a) and (d)’” (quoting In re Appraisal of Ancestry.com, Inc., 2015 WL 66825 (Del. Ch. Jan. 5, 2015)). Delaware courts have further held that “[t]he re-titling of a certified share after the demand but before the effective date violates the Continuous Holder Requirement by causing record ownership to change” (citing Nelson v. Frank E. Best Inc., 768 A.2d 473 (Del. Ch. 2000)).[1]   

In the case before it, the Chancery Court found that “on Dell’s records,” “legal ownership of [the] Funds’ shares [had] changed from Cede” to the custodial banks’ nominees between the date of the demand and the effective date of the merger. Applying Delaware precedent, the court accordingly determined that “the Funds lost their appraisal rights” “[w]hen the shares were re-titled.”

Chancery Court Suggests Delaware Courts Should Consider DTC Participants to Be “Stockholders of Record” for Purposes of Section 262 Appraisal Rights

The Chancery Court suggested that “[a] different approach” to determining who qualifies as a stockholder of record for Section 262 appraisal purposes is both “possible” and “preferable.” The court stated that if it were “writing on a blank slate,” it “would hold that the ‘records’ of the corporation for purposes of determining who is a ‘stockholder of record’ include the DTC participant list.”

The court explained that this approach would bring Delaware law in line with federal law, which “looks through Cede [and the DTC] and recognizes the custodial banks and brokers as record holders.” Moreover, the court reasoned that such an approach would “better reflect[ ] current reality.” The court explained that, “[v]iewed pragmatically, the federal policy of share immobilization compelled publicly traded Delaware corporations to outsource one part of the stock ledger ― the DTC participant list ― to DTC.” The court found that “Delaware law . . . should treat the outsourced DTC participant list as a record of the corporation, albeit one maintained by the [the]DTC.” 

If the Delaware Supreme Court were to adopt this approach, then “the Funds would [have] retain[ed] their appraisal rights” in this case “because ownership by the relevant DTC participants never changed.” However, the Chancery Court found that it was not “free to interpret the ‘holder of record’ language in this manner” given “existing precedent.” The court noted that it had “previously advocated treating DTC participants as holders of record for purposes of analyzing whether the shares they held could be voted without a DTC omnibus proxy” (citing Kurz v. Holbrook, 989 A.2d 140 (Del. Ch. 2010), aff’d in part, rev’d on other grounds sub nom. Crown EMAK Partners LLC v. Kurz, 992 A.2d 377 (Del. 2010)). On appeal in Kurz, the Delaware Supreme Court did not reach the question of “whether DTC participants should be treated as record holders,” but did express its view that “‘a legislative cure is preferable’” to resolve the question of who is a record holder for appraisal rights purposes (quoting EMAK P’rs, 992 A.2d 377). The Chancery Court here “respectfully disagree[d] with [the Delaware Supreme Court’s] expressed preference for a legislative cure,” finding “the question of what constitutes the records of the corporation for purposes of determining who is a ‘holder of record’” to be “a quintessential issue of statutory interpretation appropriate for the judiciary to address.”